The current credit crisis, recession, or whatever you want to call the mess that the world finds itself in right now has many moving parts and subplots, however when one thinks about it at the highest level it all boils down to one thing…risk. The problem with the United States’ economy is not one of liquidity like it was during the Great Depression when there was a run on banks and the government responded too slowly. Everyone’s favorite student of the Depression, Ben Bernanke, will make sure that there is plenty of money floating around out there. You can be sure of that.

Unfortunately the government's flooding of the market with money will not in itself necessarily cure what currently ails our economy. The problem that we currently face is actually a rapid, dramatic swing in sentiment from a complete ignorance of risk to extreme risk aversion.

During the bull market of the last several years, both banks and consumers levered up, consumers did so by taking on additional debt that banks made readily available and the Federal Reserve made too cheap, hedge funds levered up seeking to juice their returns, and worst of all investment banks levered up to 20, 30, and possibly even 40-1 because the SEC, Phil Grahm, and others idiotically decided to allow them to.

Leverage is great on the way up, but boy oh boy does it ever hurt on the way down. Just ask all of those CEOs like Aubrey McClendon, Chesapeke Energy’s CEO who was recently forced to sell nearly his entire stake in the company that he helped build because of a margin call. As companies delever, they are being forced to sell assets, some which are garbage and others which actually have value, into a risk averse market that has very few buyers.

Making matters worse, banks are afraid to lend money to companies, and even each other right now. They would rather use the liquidity that the Treasury and the Fed are pumping into the system to wind down their leverage to a more reasonable level than lend it to other parties.

This rapid reduction in the velocity of money means that regardless of how much cash the government prints it won’t do much good until banks begin to lend again. When banks don’t lend, many companies have problems. Credit has been the lifeblood of our recent economic expansion. When companies do not have adequate access to capital, things often grind to a screeching halt.

The painful deleveraging process is happening at the consumer level as well. As consumer confidence falls to levels never before seen and the unemployment rate rises, consumers are pulling back on spending, some are even, gasp, saving money for a rainy day. Unfortunately, those who are still willing to spend money like a drunken sailor often find themselves unable to do so as banks are unwilling to lend money, shutting down the home ATM by pulling HELOCs and actually having reasonable mortgage standards, lowering limits on credit cards, etc…

So this is where we find ourselves today. The question is, what will fix this and how bad will things get. I have been wracking my brain trying to come up with an answer to these questions and here’s what I think. The only thing that will fix the risk aversion that we are currently seeing and restore confidence to both consumers and banks is…time.

In time housing values will eventually find a bottom. When housing does bottom, banks will no longer have to worried about the mortgage backed securities, and all of the other exotic products that were developed over the past decade because the bad ones will have blown up and good ones will remain.

In time banks will be so overcapitalized that they will eventually, gradually begin to lend again.

In time, the leverage that banks took on will be wound down.

During the period which all of these things are occurring, the United States, and probably much of the rest of the world will experience a recession, the length and depth of which will depend upon how long the deleveraging, recapitalization, and restoration of confidence take.

People who claim that we are headed for another Great Depression have no idea what they are talking about. The unemployment rate hit 25% during the peak of that period. It currently sits at only 6.1%. I know that the BLS and government employment numbers probably underestimate the level of joblessness, but still even in a worst case scenario few envision the unemployment rate hitting double digits. If it does, that brings us the sort of pain that we had in the terrible, yet far from depression like 1982-1983 recession.

The Federal Reserve and the Treasury are hell bent on preventing a depression, they will print, print, print money until banks are choking on it and have to eventually lend it out. Furthermore, the next President (which I strongly suspect will be a Democrat) will work with Congress and the Senate to spend, spend, spend money to prop up the economy. The last thing that a new administration wants is a depression. They will completely forget about fiscal restraint and the budget deficit and do whatever it takes to prop up the economy giving rebates to millions of people, earmarking tons of money for new infrastructure projects, on, and on, and on…

Is this the right thing to do? I’m not sure that it is. The likely outcome of this is that the current recession will be followed by yet another bubble of some sort as well as massive inflation, followed by another possibly more painful bursting. But that will be someone else’s problem a few years down the road, not theirs. Just ask Alan Greenspan.

I'm not saying that everything is all peachy, just that it isn't as bad as the doomsday, get your canned food and guns ready, end-of-the-world crowd say it will be. Keep averaging into the market a little at a time, buying stock in quality companies at exceptional prices. Eventually things will turn around, even the Great Depression ended and this is no depression.

Deej

P.S. I am not taking anything for granted and I am doing as much research as I can on this subject. I am about to start another book on the Great Depression called The Forgotten Man.

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